An Analysis on the Exports, Production Efficiency, and Financial Access of Small and Medium Manufacturing Firms in Indonesia

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An Analysis on the Exports, Production Efficiency, and Financial Access of Small and Medium Manufacturing Firms in Indonesia

インドネシア製造中小企業の輸出、生産効率、金融へのアクセスに関する実証研究

A thesis submitted in fulfilment of the requirements for the degree of Doctor of Philosophy

Eisha Maghfiruha Rachbini 4013S304-

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Graduate School of Asia Pacific Studies (GSAPS) Waseda University, Tokyo, Japan

September, 2017

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ii Form HE(S→O)

GSAPS THE SUMMARY OF DOCTORAL THESIS

An Analysis on the Exports, Production Efficiency, and Financial Access of Small and Medium Manufacturing Firms in Indonesia

4013S304-1 Eisha Maghfiruha Rachbini Chief Advisor: Prof. Urata Shujiro

Keywords: Small Medium Enterprise, Manufacture, Export, Efficiency, Financial Access, Indonesia Small and medium enterprises (SMEs) perform important roles in

economic development. They act as engines of growth, employment absorption, and poverty reduction. In times of crisis, SMEs are also more resilient than large enterprises and become an economic buffer (Hill, 2001).

SMEs have also become prominent economic agents in Indonesia.

According to the Ministry of Cooperatives and SME data, they dominate national firm structure and employment at 99% and 97%, respectively, and contribute around 60% of national output in 2013. Indonesian SMEs also occupy a developmental role as their activities generate sources of income for poorer people in rural areas.

In an era of regional integration, one central pillar of the ASEAN’s Economic Community (AEC) priorities is the promotion of equitable economic development within the region. In line with this, the AEC also focuses on developing SMEs, since the latter is able to participate in regional production networks. Participation in regional trade through direct export and indirect production networks requires SMEs to increase their competitiveness in terms of production and trade. SMEs nevertheless face several challenges to participation in international trade owing to the high sunk cost of entering the market. A self-selecting hypothesis suggests that only productive firms accomplish entrance to the export market (Bernard and Jensen, 1999; Melitz, 2003). Strong financial capacity is also essential to compensate the costs of participation in the global market. Berman and Hericourt (2010) highlight the importance of financial access for firms’

participation in export There is also a connection, moreover, between financial access and productivity, which in turn positively affects firms’

export participation. This study thus focuses on analyzing the exports of SMEs, their production efficiency, and financial access.

This study has three main research objectives. Firstly, this research attempts to observe SMEs’ participation in export and its determinants.

Secondly, this study aims to investigate the production performance of SMEs, relating this to firm size and export participation. Lastly, this study intends to examine the impact of financial access on SMEs’ export behavior. This research focuses on analyzing small and medium firms in the manufacturing sector to gauge Indonesian SMEs’ export behavior.

This research applies Heckman’s selection model to analyze determinants of small firms’ export participation and intensity. Secondly, in order to measure production performance, this study estimates the technical efficiency of manufacturing firms across different firm sizes, export participation, and manufacturing subsectors by conducting analysis using a stochastic frontier production function (SFPF). This study additionally gauges the determinants of small firms’ technical inefficiency by performing an inefficiency effect model run simultaneously in the SFPF model. Thirdly, in analyzing financial access and export this study applies a probit regression model for panel data to estimate the extensive margin of export and applies a fixed effect panel data regression model to estimate the intensive margin of exports. This research uses survey and census firm- level datasets on the manufacturing sector from Indonesia Central of Board of Statistics (BPS).

The results of this study show that productivity, capital intensity, human capital, financial access, information access, exposure to obstacles, firm age, and firm size are all significant determinants for small firms’

participation in export Once they become exporters, productivity still

remains an important factor in explaining export intensity. This study finds evidence that exporting firms are more efficient than non-exporting firms.

In addition, the study reveals that Indonesian small firms encounter low levels of technical efficiency, compared to large firms. Small firms do not sustain an optimal level of production. There are several factors explaining the technical efficiency of small firms in the manufacturing sector, including factors relating to human capital, access to borrowing, firm size, age, and legal status. This study reveals that firms’ export participation is weakly significant in explaining technical efficiency. This may be because of their limited participation in direct export Additionally, small firms’

business linkages are significantly associated with their technical efficiency.

This finding is important as an early indication for small firms’ engagement in subcontracting.

This study conducts a further investigation into the importance of financial access on exporting behaviors in medium manufacturing firms.

Results show that financial access significantly determines firms’ export participation. In term of firm size, medium firms are less likely to become exporters, compared with large firms. This study also shows that heterogeneity in productivity is indicative of firms’ participation in export.

Moreover, the impact of firm size and productivity on exporting behavior is greater when firms have access to external finances.

Significance: This study contributes to academic literature related to studies on SMEs’ trade, productivity, and financial access. There are still limited numbers of studies about Indonesian SMEs that use extensive and comprehensive firm-level surveys and census datasets to analyze trade participation. This study provides evidence from country-specific analyses on SME exports, production efficiency, and financial access. The study moreover offers supporting evidence for policy measures on the importance of export participation, productivity, and financial access for the promotion of small and medium firms’ competitiveness.

Limitation of study: Indonesian SME data are fairly scarce. The only available data relevant for studies on the export behavior of SMEs are manufacture surveys from the Indonesian Board of Statistics (BPS).

However, these data are presented in two different dataset formats, including (i) survey on small manufacturing firms, and (ii) survey on medium and large manufacturing firms. The study of SMEs is thus conducted through analyzing small and medium firms separately.

References

Berman, N., and Hericourt, J. (2010). “Financial Factors and The Margins of Trade: Evidence from Cross-country Firm-Level Data”, Journal of Development Economics, Vol. 93, 206-217.

Bernard, A. B., and Jensen, J. B. (1999). “Exceptional Exporter Performance: Cause, Effect or Both?” Journal of International Economics, Vol.47, 1-25.

Hill, H. (2001), ‘Small and Medium Enterprises in Indonesia: Old Policy Challenges for a New Administration’, Asian Survey, Vol. 41, No.2, 248-270.

Melitz, M. J. (2003). “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity.” Econometrica, Vol.71, No.6, 1695-1725

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Acknowledgements

This PhD journey was a big milestone which gave me challenges yet invaluable lessons and academic experiences. First, I would like to thank my PhD advisor, Professor Shujiro Urata. I am honored that I had an opportunity to work on my doctoral program under his supervision. Professor Urata has been very supportive providing guidance, and advice in his expertise. He always provided insightful, constructive, and critical feedbacks for my research, particularly during seminar class. His work, expertise, and enthusiasm in economic research become motivation in pursuing an outstanding research. Professor Urata has become an inspiration to become a productive and successful academician and economist.

I would like to thank the PhD committee members, Professor Kaoru Nabeshima, Professor Atsushi Kato and Professor Kazuhiko Yokota, for their constructive and critical comments during interim. Their feedbacks are very valuable for my whole research. They also encourage and motivate to give significant contribution in this research. I also would like to thank Professor Atsuyuki Kato of Kanazawa University, a former GSAPS lecturer, for giving his time and advise in econometrics issues.

I am deeply indebted to my scholarship provider, Indonesian Education Scholarship, from Indonesia Endowment Fund for Education (LPDP), Ministry of Finance, The Republic of Indonesia. LPDP has been very generous in providing financial assistance to their scholars and supportive in motivating the scholar to achieve more in academic life and to complete the study on time.

This PhD journey is nothing without my family support. I am indebted a lot to my Husband, Ardhi, for his all-time support in pursuing my dream in higher education. My Son, Esfahan, has shown me his patience, unconditional love and supports during years I had to work on this study. My Father and My Mother also had provided a greatest supporting system to pass through this journey smoothly. Their inspirational academic achievements have also motivated me to have a balance between career and family life. I would like to thank to my sister, brother and all big family members for their prayers and supports. To all colleagues in GSAPS, Waseda University, especially in Urata Zemi, I acknowledge their constructive feedbacks during seminar class. To Indonesian PhD student in GSAPS, Indonesian Student Association in Waseda University, Indonesian families and friends in Ayase and Gyotoku, I am thankful for their warm supports, as they had become my second family here in Japan.

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List of Tables

Table 2.1. SMEs Development in Indonesia (1997-2013) 10

Table 2.2. Economic Contributions of Manufacturing Firms by Firm Size (1999-2015) 18 Table 2.3. Labor Productivity by Firm Size in the Manufacturing Sector (2000-2015) 19 Table 3.1. Distribution of Small Firms by Manufacturing Subsector 36 Table 3.2. Description of Variables and Expected Results for the Heckman Model 37

Table 3.3. Descriptive Statistics 39

Table 3.4. Estimation Results of Mean Difference Statistical Test 42 Table 3.5. Estimation Results of Probit Regression and OLS Regression 45

Table 3.6. Estimation Results of the Heckman Model 48

Table 4.1. Summary Statistics of Variables by Firm Size 65

Table 4.2. Summary Statistics of Variables by Export Participation 66 Table 4.3. List of Variables and Expected Results of SFPF 67 Table 4.4. Summary Statistics of SFPF with Inefficiency Effect Model 68 Table 4.5. Estimation Results of SFPF Regression for All Manufacturing Firms 71

Table 4.6. Results of Hypothesis Test on SFPF Model 72

Table 4.7. Estimates of Technical Efficiency and Distribution by Firm Size 74 Table 4.8. Estimates of Technical Efficiency and Distribution by Export Participation 75 Table 4.9. Estimates of Technical Efficiency by Manufacturing Subsector 76 Table 4.10. Results of SFPF Regression and Inefficiency Effect Model on Small

Manufacturing Firms 80

Table 4.11. Results of Hypothesis Tests on Small Manufacturing Firms 81 Table 4.12. Summary of Inefficiency Effect Model on Small Manufacturing Firms 84

Table 5.1. Credit gap in Indonesia by Firm Size 95

Table 5.2. Financial Access Distribution of Frequency by Firm Size 104

Table 5.3. List of Variables and Descriptions 105

Table 5.4 Summary of Statistic Descriptive 105

Table 5.5 Estimation Results of Probit Model 110

Table 5.6 Estimation Results of Panel Probit Model with Interaction Variables 111 Table 5.7. Estimation Results of Fixed-Effect Panel Regression 114

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List of Figures

Figure 1.1. Research Framework and Structure 4

Figure 2.1. SME Non-Oil and Gas Export Contribution by Sector, 2013 12 Figure 2.2. SMEs and Large Firms’ Growth of Unit Numbers (in Percentage) 13 Figure 2.3. SMEs and Large Firms’ Employment Growth (1998-2013) 14

Figure 2.4. GDP Growth by Firm Size 14

Figure 2.5. Export Growth by Firm Size (1998-2013) 15

Figure 2.6 Distribution of SME Output by Economy Sector 16

Figure 2.7. SME share of GDP in the Manufacturing Sector (2011-2015) 17 Figure 4.1. Technical Inefficiency in Production of One-Unit Input and Output 56

Figure 5.1. Bank Borrowing by Firm Size (2010-2015) 96

Figure 5.2. Bank Borrowing Interest Rate by Firm Size (2010-2015) 97 Figure 5.3. Non-Performing Loan by Firm Size (2010-2015) 98

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List of Abbreviations

TSLS Two-stage Least Square ADB Asian Development Bank

AEC ASEAN Economic Community

APEC Asia-Pacific Economic Cooperation

ASEAN The Association of Southeast Asian Nations

BIPIK Small Industry Development Program or Program Pembinaan dan Pengembangan Industri Kecil

BPS Indonesia Statistics Board or Badan Pusat Statistik CEO Chief Executive Officer

EBRD European Bank for Reconstruction and Development FTA Free Trade Agreement

GDP Gross Domestic Product

IFC International Finance Corporation IMF International Monetary Fund IV Instrumental Variables

KGMHLBC Kumbhakar, Ghosh and McGuckin, Huang and Liu, and Battese and Coelli Model KIK Small Investment Credit or Kredit Investasi Kecil

KMKP Working Capital Credit or Kredit Modal Kerja Permanen KUK Small Enterprises Credit or Kredit Usaha Kecil

KUR Micro and Small Business Credit or Kredit Usaha Rakyat

KURBE Export-oriented SME credit or Kredit Usaha Rakyat Berorientasi Ekspor LIK Small Industry Cluster or Lingkungan Industri Kecil

LR Likelihood Ratio

MCOSME Ministry of Cooperatives and SMEs MSME Micro Small and Medium Enterprise NGO Non-Governmental Organization NPL Non-Performing Loan

OLS Ordinary Least Square

PEGEL Small Business Development Assistance or Pengembangan Usaha Golongan Lemah

PIKIM Small-scale Enterprises Development Program or Program Pengembangan Industri Kecil Mengengah

SBY Susilo Bambang Yudhoyono

SFPF Stochastic Frontier Production Function SME Small Medium Enterprise

SOE State Owned Enterprise TFP Total Factor Productivity Translog Transcendental-logarithm

UPT Technical Support Unit or Unit Pelaksanaan Teknis WTO World Trade Organization

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Chapter 1 Introduction

1.1 General Background

In most developing economies, small and medium enterprises (SMEs) have an important role in economic development. As dominant actors, they are an engine of growth, employment provision, and they also contribute to poverty reduction. SMEs have also become dominant enterprises beyond developing economies. On average, they contribute around 35% to the national output, in terms of gross domestic product (GDP), in developing countries, and around 50% of national output in developed countries, as well as providing around 70% of total job creation (WTO, 2016).

In Asian economies, the contributions of SMEs also vary, but still dominate national economies. Micro, small, and medium enterprises (MSMEs) contributed more than 97% of enterprises in the national structure of firms for China and Thailand in 2012, Cambodia, South Korea, The Philippines, and Vietnam in 2011, and Malaysia in 2010 (ADB, 2014). In terms of GDP and employment, SMEs produce, on average, about 38% of total output and employ about 66% of total labor in Asian economies, while in the case of advanced Asian economies like Japan, SMEs contribute about 99% of total firms and employ about 70% of total labor (Kuwahara, et.al., 2015). In South Korea, another advanced economy in Asia, SMEs provide about 90% of total employment and contribute about 50% of total GDP on average during the period 2007 to 2012 (ADB, 2014).

As regards ASEAN economies, SMEs dominate firms and employment types.

However, their contributions to GDP are still at a moderate level, lower than those in more advanced Asian economies. According to data for ASEAN economies, in Thailand, SMEs generate about 80% of employment and around 37% of the nominal GDP in 2012 (ADB, 2014). In addition, Malaysian SMEs, which employ 50% of national workers and contribute 33% of national output. According to Morougane (2012), Indonesian SMEs provide about 99% of the total number of firms and 97% of employment. However, according to Indonesian Statistics Board (BPS), they only generated about 60% of national GDP in 2013.

The role of SMEs has also been appraised, as they often comprise dynamic entities facing more challenging globalized and integrated economies. As is the case in Asian economies, rapid growth since the late 20th century has prompted the region to become a global factory, a term employed by Kawai and Wignaraja (2009; 2010; 2011). Kawai and

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Wignaraja (2010) further explain that rapid growth in Asian economies in the 1980s was triggered by production networks established by multinational companies and pioneered by Japan, who expanded their business interests in search of low-cost labor. This reallocation of production was directed to Asian countries that have advantages in production resources, including cheaper labor and natural resources, such that production costs could be minimized.

At the same time, developing Asian economies such as Indonesia became more outward- oriented in their policy development. For example, they promoted an export-oriented manufacturing sector, building infrastructure, and invested in human capital. They also aimed at attracting investment from more developed Asian economies like Japan.

Market-driven, intra-regional trade within Asia has taken place more intensively. This has led to a new trend of regionalism and integration known as FTA-led regionalism (Kawai and Wignaraja, 2011). Free trade agreements (FTA) among these countries are designated to reduce trade barriers. Advanced Asian economies, including Japan, China, and South Korea, are eager to formulate their regional trade strategies, and, at the same time, ASEAN countries intend to expand and participate in trade and production networks. Additionally, as the production networks have been established in the manufacturing sector in emerging Asian economies, SMEs have also become involved in the network, as they support the larger scale operations in the sector, particularly in their capacity as a subcontractor for the part and component industries. Through these schemes, improving production through innovation, knowledge and technology capabilities, especially in the manufacturing sector, are expected to expand with SMEs participation in production network.

Regionalism within Asia has been signified by FTA proliferations; 86 FTAs concluded in 2015, compared to 3 FTAs in 2000 (ADB, 2015). Regional integration in ASEAN has also furthered, as the ASEAN Economic Community (AEC) was officially implemented at the end of 2015. In the era of AEC, participation in production networks and involvement in the global value chain are expected to encounter greater opportunities as well as challenges, particularly for ASEAN member states. Additionally, SMEs are also considered agents for equitable economic development in the ASEAN region, as is written in the AEC Blueprints. Therefore, strengthening SMEs in ASEAN has become a priority for preparing the implementation of AEC. This effort is aimed at supporting inclusive growth, employment, and solving the middle-income trap (ADB, 2014). In line with this, the AEC has formulated a strategy aimed at improving human resources, financial access, technology, innovation, and market internationalization for SMEs, so as to improve SMEs competitiveness in more integrated ASEAN economies.

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In brief, it has been clearly explained that the role of SMEs has dynamically changed as regional integration has developed, particularly within the ASEAN region. The same goes for Indonesia, as a member of the AEC with dominant numbers of SMEs in the national economy; SMEs therefore occupy a role as supporting entities in the global production network, particularly in the manufacturing sector. Considering SMEs’ role to participate in the global economy, as is the case of Indonesia, SME-related policies and measures should be more focused on strengthening SMEs participation in international activity, and formulating a strategy to boost SMEs productivity and competitiveness.

Against this background, this study will focus on the topic of SMEs participation in international trade, particularly in terms of strengthening the position of SMEs in the new era of integration. To benefit from deeper integration and the global production network, Indonesian SMEs need to be more productive and more competitive, so that they can participate more in international trade, both indirectly and directly. To this extent, this study intends to examine Indonesia’s SMEs export behavior, productivity, and financial access, all of which are prominent aspects for competing in the new era of globalization.

The remainder of this chapter is organized as follows: Section 1.2. explains the research structure, including research questions and the study’s hypothesis. This section also includes a brief review of the approach and methodology conducted in this study, and explains the chapter arrangement of the thesis. Section 1.3 highlights the research significance of the study.

1.2 Structure of Thesis: Research Questions, Hypothesis, and Methodology

Regarding the main objective explained above, this study will examine SMEs export behavior, productivity, and financial access. This study uses comprehensive and extensive firm-level data on the Indonesian manufacturing sector from the Indonesia Statistics Board (BPS), which consist of two datasets, as follows: (i) a survey of the small manufacturing sector, and (ii) a survey of the medium and large sector. This study performs several quantitative approaches and methodologies, and uses econometrics tools to analyze both cross-sectional data and panel data, which will be discussed in the explanation below.

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Figure 1.1. Research Framework and Structure

In Chapter 2, the development of SMEs in Indonesia is elaborated upon. This chapter also emphasizes policies and measures related to SMEs imposed by the Indonesian government over two periods: before and after the Asian financial crisis, until the recent period of study. There will be three main chapters elaborating upon empirical evidence from quantitative research conducted for this study, related to SMEs export behavior, production performance, and financial access. Owing to the availability of data, Chapters 3 and 4 will focus on small manufacturing firms, while Chapter 5 will expand on the analysis of medium manufacturing firms.

Chapter 3 will investigate small firm participation in export and its export intensity.

The Chapter further asks several research questions related to small firm export behavior and its determinants, as follows: (i) Do exporting small firms have different productivity levels and characteristics compared to non-exporting small firms? (ii) What are the determinants of small firms’ export behavior? (iii) How does productivity relate to the export behavior of small firms?

Using Heckman model, this study anticipates that exporters and non-exporters differ in their productivity and characteristics, for the case of Indonesian small manufacturing firms. Productivity, factors related to production, and firm characteristics are also expected to be significant in influencing firm participation in export and export intensity.

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Secondly, Chapter 4 will continue to further the analysis of Indonesian small manufacturing firm production performance, by estimating firm’s technical efficiency as a measure for production performance. This chapter also intends to examine and compare the technical efficiency of manufacturing firms across firm sizes, export activities, and manufacturing subsectors. There are several research questions regarding the objectives in this chapter, namely: (i) Are small firms less efficient in terms of production? (ii) Do exporting firms produce output more efficiently? (iii) How does technical efficiency differ across manufacturing subsectors? (iv) If small firms are less efficient, what factors explain these inefficiencies?

Performing Stochastic Frontier Production Function (SFPF) regression, this study hypothesizes that small firms have a lower technical efficiency compared to larger firms.

Moreover, exporters are assumed to perform more efficiently than non-exporters in the manufacturing sector, while technical efficiency varies across manufacturing subsectors. As this study presumes that small firms encounter lower efficiency levels, it intends to investigate factors explaining the efficiency of small firms. There are several factors which are expected to explain technical efficiency, including firm size, factors related to human capital, export participation, financial access, business linkages, and firm partnerships.

Lastly, Chapter 5 will examine the role of financial access on export behavior. This study also intends to investigate how firm size and productivity relate to the importance of financial access on export behavior. As a way of extending this study to incorporate medium firms, the analysis includes medium and large manufacturing firms in examining export participation and export intensity. In this chapter, there are several research questions raised focusing on financial access and export behavior, which are as follows: (i) Does financial access impact on firm’ export behavior? (ii) Does firm size matter in explaining the impact of firms’ access to finance on export? (iii) How does productivity relate to financial access and export?

In Chapter 5, the study anticipates that financial access significantly and positively effects on both export participation and export intensity. Secondly, smaller firms supposedly have less access to external finance compared to larger firms, thus limiting their participation in export. The impact of productivity on export participation is expected to be larger where firms have access to finance. As regards empirical analysis, this chapter applies a probit model for estimating the extensive margin of exports, and a fixed-effect panel model for examining the intensive margin of exports.

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Finally, Chapter 6 concludes the empirical results of the study. In this chapter, findings and contributions from the quantitative analysis chapters are summarized. Further to this, the chapter offers policy implications drawn from the empirical findings of the study.

1.3 Significance of the Study

This study contributes to academic literature on the topic of SMEs’ export behavior, productivity, and financial access. There is a limited number of empirical research on Indonesian SMEs, specifically regarding economic analysis that uses large firm-level datasets, and that examines international trade. Previous empirical studies examine SMEs in Indonesia using aggregate data on SMEs economic development, and contribution to sectoral or national-level analysis (Tambunan, 2008; Tambunan, 2009; Berry, et. al. 2002). In many other research projects, surveys are used with cluster or sector samples for examining SME development in Indonesia (Berry and Levy, 1999; Pribadi and kanai, 2011; Rothenberg et.al., 2016; Sandee, et. al. 1994). To this extent, the research in this study aims to address gaps in studies related to SME participation in international trade, and production performance.

By using extensive micro-level datasets, this study also extends previous literature on SME export participation, by focusing empirical studies on the area of study. This study uses comprehensive and extensive firm-level data on Indonesian manufacture firms from the Indonesian Statistics Board (BPS). Moreover, this study attempts to conduct firm-level analysis on SMEs exports, production performance, and financial access, and furthermore observes empirical evidence from country-specific case studies that provide similar results in previous related studies.

By obtaining empirical results on SMEs export behavior, productivity, and financial access supporting evidence and analyses can be provided to formulate recommendations for SMEs policies and measures. The implementation of these policies will improve SMEs engagement in international trade, productivity, and financial capacity. Since the implementation of AEC has taken place, SMEs participation in international trade has generated more concern and support. Policy makers must promote SME competitiveness and productivity as more challenges in the global economy continue to emerge. Export participation, productivity, and financial access, are all critical aspects for SME development in Indonesia.

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Chapter 2

SMEs Development in Indonesia

Summary

This chapter considers the development of SMEs in Indonesia. This section mainly discusses how SMEs developed since the pre-crisis and post-crisis 1997-98 era until the recent regime of the Indonesian government. SMEs have been important players in the Indonesian economy. As dominant economic agents, they contribute to national employment and national output. They also act as development agents, improving welfare and income, particularly in rural areas. Considering SMEs’

importance, some policies related to them have been imposed by the government, which indicates that SMEs have become a priority for Indonesian policy makers.

In general, these imposed policies are in the forms of financial assistance and technical assistance. Moreover, the government has also implemented some regulations to support SMEs. This chapter also provides some evaluation of the implementation of government policies related to SMEs.

2.1. Definition of SMEs in Indonesia

SMEs have become a priority in government policies, and thus some regulations are being imposed to support their existence and development. The Definition of SMEs are also understated by regulation and law. Across periods, definitions of SMEs stated by regulation and law are also changing. Regulation No. 9/1995 was the first basis law for SMEs definition in Indonesia, imposed after Asia-Pacific Economic Cooperation (APEC) forum held in Bogor, Indonesia in 1994. By using the category of assets, this regulation defines small firms as those having assets of less than or equal to Rp. 200 million. This regulation became the first formal regulation and foundation law to promote small firms in Indonesia. Previously, there had been no formal regulations related to, nor any policies that formally supported small firms. By imposing this regulation, the government had shown the intention to develop SMEs and put them into their political agenda to promote national employment, output, and foreign trade. Further, Presidential Instruction No. 10/1999 was imposed to outline medium- sized firm definition, which categorized those owning assets equal to Rp. 200 million to Rp.

10 billion as belonging to the group.

As SMEs develop further, in terms of unit numbers, they grow larger and more dominant in the economy. They also contribute to national employment, as they account for about 97% of total employment in Indonesia. To accommodate these firms’ dynamics, micro firms, previously known as homebased enterprises or cottage industries, were defined in a new regulation as firms having assets of less than Rp. 50 million. By adding micro firms to

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the firm structure, the new regulation was imposed under Regulation No. 20/2008, replacing Regulation No. 9/1995. This new regulation also redefined other firm sizes, as follows: small firms as having assets from Rp. 50 million to Rp. 500 million and medium-sized firms as having assets from Rp. 500 million to Rp. 10 million. This new regulation also set a definition based on sales, in which micro firms were categorized as firms selling less than Rp.

300 million, small firms as having total sales of between Rp. 300 million and Rp. 2.5 billion, and medium-sized firms as earning between Rp. 2.5 billion and Rp. 50 billion from their sales. This regulation has been the basis for the definition of SMEs until recent years.

Although the definition of SMEs has been regulated by law, in several cases, some government institutions still use no uniform definitions for SMEs. Indeed, several definitions of SMEs are used across different government institutions. Hill (2001) and Thee (2006) agree that there is no consistent single definition of SMEs in Indonesia, since each government agency uses a different definition. In Indonesia, the definition of SMEs also changes due to a different basis and different measurements in the databases provided by the government. For instance, since 2008 until recently, micro enterprises were added to firm categories on the Ministry of Cooperatives and SME (MCOSME) database. There are at least three definitions of SME used in certain government institutions. First, the definition by assets and total sales, stated under Regulation No. 20/2008, is mostly used by the MCOSME. Hereafter, in this current study, this type of firm category refers to the MCOSME definition.

Second, the Ministry of Industry uses the employment category to define small and medium-sized firms in the manufacturing sector. Regarding Regulation No. 3/2014, the Ministry of Industry defines small firms in the industry sector as those employing fewer than 20 workers and owning assets worth less than Rp. 1 billion. This regulation became the base regulation for the Ministry of Industry policy as related to the manufacturing sector. In line with this, the BPS (Indonesia Statistics Board) categorizes manufacturing firms into micro firms (1-4 workers), small firms (5-19 workers), medium-sized firms (20-99 workers), and large firms (100 workers and above). This study, hereafter, refers to the BPS definition, which uses the employment category to define SMEs in the manufacturing sector. Other than government institutions, the World Bank also refers to the BPS definition of SMEs for Indonesia when they conducted an enterprises survey, in which firms were categorized into small (5-19 workers), medium-sized (20-99 workers) and large (100 workers and above).

Several firm-size categories are used in several studies on Indonesian SMEs. Different from the definition of SMEs stated in the government’s category, several studies have defined Indonesian SMEs. Hill (1990) argues that small industrial firms which have 5-9

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workers are appropriate only when the industrial sector is still in the early stage of development, i.e., the infancy stage. As the industrial sector develops, Hill (1990) states that a broader definition of small industrial firms, e.g., 5-49 workers, is necessary. Hill (1990) also points out that definition by assets is not appropriate. In line with this, Thee (2006) suggests that there is a need for care when defining SMEs, as a broad definition may cause problems and difficulties when it comes to evaluate programs for SMEs. A study by Wengel, and Rodriguez (2006) categorizes firms in the manufacturing sector into small (20-99 workers), medium-sized (200-499 workers), and large (500 workers and above). Their categories apply only in medium-sized and large manufacturing sectors due to data availability.

Considering the various definitions for SME in Indonesia, this current study uses the BPS method of defining SME categories by employment. Since this study uses surveys on the manufacturing sector in conducting this research, this study defines SMEs as follows:

small firms (fewer than 20 workers), medium-sized firms (20-99 workers), and large firms (100 workers and above), which correspond to the firm size classification in the survey on the manufacturing sector used in this study.

2.2. The Roles of SMEs in the Indonesian Economy

SMEs have been considered as important economic agents in Indonesia. Hill (2001) highlights several reasons why SMEs are important and represent an interesting subject in economic studies. According to several studies, SMEs make an important contribution to the national economy in terms of employment and total output. They are also dominant economic players in terms of unit numbers. Table 2.1 also shows that the share of SMEs is about 99%

out of the total number of enterprises in Indonesia. In addition, SMEs also dominantly provide national employment. Table 2.1 shows SMEs’ share of employment was about 99%

during 1997-2013. SMEs provide large numbers of jobs as their unit numbers of enterprises grew persistently after the Asian financial crisis (1997-1998), as can be seen in Table 2.1. In terms of unit numbers, SMEs grew around 3% annually in the period after the crisis, during 1999-2013. The data illustrate that new SME establishments entered the market and continued to provide employment in the national economy, particularly for the periods after the crisis, i.e., 1999-2013. In terms of national output, the SME contribution is about 57%

annually, which is slightly above that of large enterprises.

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Table 2.1. SMEs Development in Indonesia (1997-2013)

No. Indicators Unit 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 1 Number of

Entities Unit

Thousand 39,765 26,814 37,912 39,784 39,964 41,944 43,460 44,777 47,017 49,022 50,146 51,410 52,765 53,824 55,206 56,535 57,896 2 Growth in

Number of Entities

Percent -7.42 2.98 4.94 0.45 4.96 3.61 3.03 5 4.26 2.29 2.52 2.64 2.01 2.57 2.41 2.4

3

Share in number entities

Percent 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 99.99 4 Employment Unit

Thousand 65,209 64,314 67,169 72,704 74,687 77,808 81,942 80,447 83,587 87,910 90,492 94,024 96,211 99,402 101,722 107,658 114,144 5 Growth of

Employment Percent -1.37 4.44 8.24 2.73 4.18 5.31 -1.83 3.9 5.17 2.94 3.9 2.33 3.32 2.33 5.83 6.03

6 Share in

Employment Percent 99.4 99.4 99.4 96.42 96.18 96.27 96.3 96.23 96.85 97.3 97.27 97.15 97.28 97.32 97.24 97.16 96.9

7 GDP Contribution (constant price 2000)

Rp.

Trillion 249.6 219.2 219.8 760.1 791.6 829.6 876.1 924.5 979.8 1,032.6 1,099.3 1,165.8 1,212.6 1,282.6 1,369.3 1,504.9 1,536.9

8 Growth of GDP by SMEs

Percent -12.18 0.26 245.8 4.15 4.8 5.61 5.52 5.97 5.4 6.46 6.04 4.02 5.77 6.76 9.9 5.89

9

GDP share (constant price 2000)

Percent 57.61 58.23 57.93 54.69 54.96 55.12 55.55 55.81 55.95 58.49 58.44 58.35 58.05 57.83 57.6 57.48 57.56 10 Export Rp.

Trillion 39.3 129.6 52.6 75.5 80.8 87.3 77.1 95.6 110.3 123.8 140.4 178.1 162.3 175.9 187.4 166.6 182.1 11 Export

Growth Percent 229.92 -55.41 43.45 7.15 7.97 -11.68 23.93 15.48 12.17 13.41 26.82 -8.85 8.41 6.56 -11.1 9.29 12 Export

Share Percent 33.34 33.59 18.37 19.35 19.02 17.22 20.15 20.3 20.28 17.95 17.66 18.1 17.02 15.81 16.44 14.05 15.68 Source: Ministry of Cooperatives and SMEs

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SMEs also play an important role in rural and regional development, as they are scattered throughout the regions and rural areas. SMEs’ businesses are also mostly conducted in local areas and developed by the local community, as they utilize resources to produce locally-sourced products. They also serve as income sources for local people, particularly for low income households in rural areas. SMEs are able to produce specific products that cannot be produced and sold by larger firms, due to their efficiency and economies of scale. Being able to serve the local community is related to SMEs’ ability to penetrate new and niche markets. Indeed, SMEs’ innovation in responding to any market challenges and opportunities, due to their flexibility in business organization, might lead them to establish such markets (Urata, 2000).

Hill (2001) also mentions that SMEs support growth in the Indonesian economy, particularly as they have become the base for the industrial sector. SMEs generate output which cannot be produced by large enterprises in this sector. These kinds of products cannot be processed in large firms’ mass production facilities, but can only be produced by the specific skills and technology provided by SMEs. Therefore, SMEs produce those kinds of products more efficiently than large firms can. For example, SMEs might have advantages in accessing cheaper local raw material and resources so that they can produce specific outputs more efficiently than large firms can. Acting as subcontractors, SMEs can adopt innovative and knowledge from large firms, as their demand for parts and components requires high quality and standards to be fulfilled by SMEs (Berry and Levy, 1999). SMEs innovation to create specific products leads to dynamic linkages between firms in the industrial sector (Urata, 2000). As SMEs become part of the production network in the industrial sector, their existence acts as a fundamental structure for well-functioning manufacturing sectors in producing output, which triggers growth in the industrial sector. Therefore, efficient SMEs should be encouraged to promote economic growth, particularly in the industrial sector. In Indonesia, Tambunan (2008) mentions that only a few Indonesian SMEs participate in subcontracting, particularly in the parts and components industry, since they lack the skills and technological capacity required in the production network.

As well as contributing to the domestic economy, SMEs also sell their products in the international market through export participation. SMEs’ contribution to national total export was about 16% in 2013. In contrast, their export contribution was about 33% in the period before crisis. Thus, their contribution is decreasing; recently, their share has not reached the same percentage as previously. Based on the sectoral level, SMEs’ exports are coming from the manufacturing sector (89%), agricultural sector (10%) and mining sector (1%), as

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displayed in Figure 2.1. In the manufacturing sector, the following sectors, that is, the manufacture of food, beverages, and tobacco (21%); the manufacture of transport machinery, and equipment (17%); the manufacture of chemicals, fertilizers, and rubber (22%); and the manufacture of basic metal (15%), made a major contribution to SMEs’ exports in 2013. In the manufacturing sector, SMEs might also indirectly participate in the global market by becoming subcontractors to global firms and by indirectly selling those exported products through trade networks and intermediaries instead of participating directly in export. These practices can be found, for instance, in the manufacture of furniture, garments, and textiles (Berry and Levy, 1999).

Figure 2.1. SME Non-Oil and Gas Export Contribution by Sector, 2013

Source: Ministry of Cooperatives and SMEs, 2013

SMEs are also more resilient in times of crisis due to their flexibility in adapting to any changes. According to Thee (2006), SMEs are more flexible in making decisions in response to any changes as they have a less complicated business structure and organization compared to large enterprises. Another reason that explains SMEs’ resilience to crises is their independence from any foreign debt compared to large firms. They are less vulnerable to any volatility and depreciation on the exchange rate, since they do not borrow foreign loans and are not heavily dependent on imported raw materials in their production.

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Figure 2.2. SMEs and Large Firms’ Growth of Unit Numbers (in Percentage)

Source: Ministry of Cooperatives and SMEs, 2013

The data in Figure 2.2 and Figure 2.3 show SMEs’ growth, in terms of numbers, employment, and output, after the emergence of the Asian financial crisis. Figure 2.2 displays the growth of SMEs and large firms in terms of unit numbers, during the crisis of 1997 to 2013. The effect of the Asian financial crisis on the growth of SMEs was not as large as that of large firms. However, while there was negative growth in SMEs’ unit numbers due to the crisis, this negative impact was greater for large firms (-12.7%) compared to MSMEs (- 7.42%). During 1999-2000, there was an immediate and significant increase in the growth of large firms. It should not be interpreted as a structural change in large firm growth, since there was a change in the economic data base year in 2000 according to the official statistics.

This, therefore, affected changes in the economic indicators and measurements in economic structures, including numbers of firms recorded by the authorities, and aggregated data in production, e.g., constant GDP calculation. In the period from 2000 onward, SMEs’ growth was relatively more stable compared to the more fluctuating growth of large firms. As for the global financial crisis, large firms experienced a negative impact on growth, i.e., a decline in unit numbers by -3.8% in 2010. In contrast, SMEs’ unit numbers still grew at 2.02% in 2011, a rather slower growth rate than in 2010, when it was at 2.56%.

-30 -20 -10 0 10 20 30 40 50

-50.00 -25.00 0.00 25.00 50.00 75.00 100.00 125.00 150.00 175.00 200.00

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 SMEs Growth (%)

Large Firms Growth (%)

Large Firms SMEs

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Figure 2.3. SMEs and Large Firms’ Employment Growth (1998-2013)

Source: Ministry of Cooperatives and SMEs (Compiled)

The impact of the global financial crisis is illustrated in Figure 2.3. After the global financial crisis, SMEs’ growth in terms of employment was relatively stable at 2% in 2011, but it began slowing down due to the emergence of the global financial crisis. In contrast, during the global financial crisis, large firms suffered a greater impact, as their total employment grew at a negative rate, i.e., -2.3% in 2009. Figure 2.4 shows that SMEs’ output growth was at a slower rate, i.e., 5.3% in 2009, compared to 6.3% in 2008. However, SMEs’

growth is relatively stable during the period 2000-2013. Meanwhile, large firms showed a decreasing growth rate from 5.9% in 2008 to 4% in 2009. There was also a negative shock in 2006 due to the reduction in the fuel subsidy in 2005, which had a greater negative impact for large firms than for SMEs.

Figure 2.4. GDP Growth by Firm Size

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Regarding the impact of the financial crisis on export, Figure 2.5 shows the growth of export by firm size during the period 1997-2013. The aftershock effect of the Asian financial crisis can be seen in the huge jump in export growth, of about 230%, in 1998 as depreciation of the Rupiah meant the value of exports increased. However, this was followed by a large fall in export growth, both for SMEs and large firms. SMEs’ export growth was affected more than that of large firms. For instance, in 1998, SMEs experienced a negative export growth (-59%), which showed a greater collapse than that of large firms. When the global financial crisis occurred, export growth for SMEs was also negatively affected at -9%, compared to that of large enterprises, which showed a decrease in export of -2%. This indicates that SMEs that are linked to the international market, for instance, exporting their products, importing raw materials, and borrowing foreign debt, will suffer a greater impact from financial crises. Conversely, domestic-oriented SMEs are less affected by and more resilient to financial crises, since they are not directly harmed by the negative impact of the crisis. However, the study of Thee (2006) argued that SMEs that were involved in exports were more resilient than large enterprises with large debts, while domestic-oriented SMEs survived better than outward-oriented SMEs, for instance, SMEs engaging in exporting or importing raw materials from abroad.

Figure 2.5. Export Growth by Firm Size (1998-2013)

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2.3. SMEs Development in the Manufacturing Sector

This section discusses SMEs’ contribution as an engine of growth in the Indonesian economy, particularly their contribution in the manufacturing sector. Back in the 1990s, the Indonesian economy had been driven by substantial growth in the manufacturing sector.

Figure 2.6 shows SMEs’ output share of the manufacturing sector as a portion of total output, compared to other economic sectors. This figure illustrates to what extent SMEs contributed to the manufacturing sector during the period after the Asian financial crisis. SMEs generated their output dominantly in trade, hotel and restaurant sector for about 27% from 2000 to 2013. SMEs’ share of output in agricultural sector contributed about 24% to their total output, while their contribution in the manufacturing sector, positioned at the third rank, was about 23% during the same period. This figure also shows that SMEs’ contribution to the manufacturing sector has been decreasing, with a reduction from 13% in 2000 to 9% in 2013.

Figure 2.6 Distribution of SME Output by Economy Sectors

In the manufacturing sector, it has long been argued that large firms make a greater contribution than SMEs, since large firms have benefited from more privileges and special support from government policy in the industrial sector, particularly during the early stage of industrialization since the 1970s. Industrial policies also view SMEs as becoming part of industrial sector, indeed, as forming a basis for industrial sector, given their roles as suppliers and subcontractors (Berry and Levy, 1999; Hill, 2001). Figure 2.7 shows SMEs’ contribution to the output in the manufacturing sector compared to large firms’ output in the same sector.

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Recently, SMEs generated around 34% of total output in the manufacturing sector during the period 2011-2015 (constant price year 2000), while large firms contributed about 66% in the same period, as displayed in Figure 2.7.

Figure 2.7. SME Share of GDP in the Manufacturing Sector (2011-2015)

Note: Non-oil and gas Manufacture, GDP Constant year 2000 Source: Ministry of Industry

In the manufacturing sector, SMEs make an important contribution to unit numbers and employment. Table 2.2 shows the data on Indonesian manufacturing firms by firm size.

These data were collected from the Indonesian Statistic Board; therefore, the firm size category uses the BPS definition, which is based on the employment size category. Micro and small firms, that is, firms employing fewer than 20 workers, are still dominant in terms of unit numbers in the manufacturing sector, accounting for about 99% of firms’ structure during the period 2000-2015. However, this firm size group provides, on average, around 60% of the total employment in the manufacturing sector.

The data in Table 2.2 also show that small firms’ share of the manufacturing output is limited. The manufacturing sector’s output is mostly generated by medium-sized and large firms (more than 20 workers), which account for about 90% of the total manufacturing output. This category of manufacturing firms created 40% of total employment on average during 2000-2015. In contrast, micro and small manufacturing firms produced only about 10% of the total output in the manufacturing sector in the period 2004-2015. As for value added in the manufacturing sector, micro and small firms contributed about 9% on average during the period 2011-2015, showing a decreased share compared with 11.6% during the period 2004-2008. In addition, they provided 60% to 70% of employment in the manufacturing sector during the period 2000-2015. This pattern, in which small firms

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dominate regarding number of units and employment while larger firms dominate in the share of output and value added is also found in the previous dataset provided in Hill (1990) for the year 1986, and by Hayashi (2003) for the period 1986-1999.

Table 2.2. Economic Contributions of Manufacturing Firms by Firm Size (1999-2015)

Numbers of Units

Year Micro Firms Small Firms Micro-Small Firms Medium-Large

Firms Total

Share Growth Share Growth Share Growth Share Growth Growth

2000-2003 90.27% 1.33% 8.93% 1.20% 99.20% 1.32% 0.81% -2.02% 1.29%

2004-2008 90.43% 4.21% 8.74% 2.42% 99.17% 4.04% 0.83% 6.19% 4.05%

2011-2015 87.73% 6.08% 11.56% 17.76% 99.28% 6.09% 0.71% 1.62% 6.06%

Employment

Micro Firms Small Firms Micro-Small Firms

Medium-Large

Firms Total

Share Growth Share Growth Share Growth Share Growth Growth 2000-2003 42.77% 1.81% 16.52% -0.70% 59.29% 1.08% 40.71% 0.25% 0.72%

2004-2008 42.48% 1.34% 18.28% 5.72% 60.76% 2.55% 39.24% 1.02% 1.88%

2011-2015 44.51% 6.33% 25.56% 17.82% 70.06% 7.13% 36.05% 2.79% 5.23%

Total Output (in IDR Billion, Current Price) Micro Firms Small Firms Micro-Small Firms

Medium-Large

Firms Total

Share Growth Share Growth Share Growth Share Growth Growth 2000-2003 4.53% 16.39% 4.13% 11.74% 8.66% 14.11% 91.35% 15.23% 15.09%

2004-2008 5.27% 17.49% 5.60% 29.06% 10.87% 22.83% 89.13% 18.06% 17.72%

2011-2015 4.47% 85.21% 5.56% 50.79% 10.04% 59.38% 89.97% 14.26% 15.24%

Value Added (in IDR Billion, Current Price)

Micro Firms Small Firms Micro-Small Firms Medium-Large

Firms Total

Share Growth Share Growth Share Growth Share Growth Growth 2000-2003 3.70% 18.67% 3.78% 13.43% 8.96% 16.15% 91.04% 14.64% 14.64%

2004-2008 5.39% 13.32% 5.83% 39.23% 11.65% 23.89% 88.35% 17.32% 17.40%

2011-2015 4.25% 78.27% 4.84% 58.14% 9.09% 64.20% 90.91% 17.29% 17.93%

Source: BPS, Author’s calculation

It is commonly believed that SMEs perform poorly compared to large firms, which affects their competitiveness in the market. Regarding production performance, Table 2.3 below shows firm labor productivity in the manufacturing sector across different firm sizes.

In this table, labor productivity is measured as a ratio of value added to total employment in the manufacturing sector. It is shown that all manufacturing firm sizes experienced an increase in labor productivity during the period 2000-2015. Indeed, labor productivity of medium-sized and large manufacturing firms was more than double in the year 2015,

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compared to the year 2000. The data also show that micro and small firms were less productive than medium-sized and large firms. Comparing micro firms with small firms, the data show that small firms performed better than micro firms. The increase in productivity of small firms, from 6.55 to 27.3 during 2000-2003 and 2011-2015 respectively, was greater than that of micro firms. Using similar data, Liedholm and Mead (1999) also found that in other countries, SMEs typically developed more significantly than did micro firms.

Table 2.3. Labor Productivity by Firm Size in the Manufacturing Sector (2000-2015)

Year Micro Firms Small Firms Micro-Small

Firms Medium-Large

Firms Total

2000-2003 3.48 6.55 4.33 63.66 28.46

2004-2008 6.86 16.08 9.67 115.14 50.95

2011-2015 12.56 27.27 17.45 291.33 116.61

Note: Labor Productivity in Value added per worker, in IDR million Source: BPS, compiled.

Regarding their roles in the economy, it has been explained that SMEs have become important economic players in the national economy. SMEs differ from the large enterprises in their characteristics. Due to their small scale and limitations, they also face a problem with competitiveness in the market. Moreover, they encounter several problems related to their performance, such as productivity and exports. They also find difficulties in accessing financial sources, accumulating capital, and obtaining raw materials. These circumstances provide a supportive argument for SMEs’ policies, particularly policies related to promoting employment, output, equality, and welfare distribution. Thus, as mentioned previously, in the case of Indonesia, SMEs have become a priority in government policies. In the following sub-sections, SMEs policies imposed by Indonesian government will be discussed in more detail.

2.4. SMEs Policies in Indonesia

In general, policies related to SMEs take the form of financial and technical assistance.

This subsection discusses in detail some of the regulations imposed by the government to support the development of SMEs. The subsection is divided into two parts: (i) the pre-Asian crisis 1997 era, and (ii) the post-Asian crisis era.

2.4.1. Pre-Asian Crisis Era

In the 1970s and 1980s, the government implemented several policies to support the development of SMEs. Policies in the form of financial subsidies for small firms were implemented in 1973, such as small investment credit (KIK) and working capital credit

An Analysis on the Exports, Production Efficiency, and Financial Access of Small and Medium Manufacturing Firms in Indonesia